Case Study- PC Problems plc
PC Problems plc is a (fictitious) company engaged in the servicing of personal computers on a carry-in basis. The company started out several years ago as a small shop working on household appliances. During the course of normal business, several customers owning small computers asked the shop whether they had the capacity to fix problems with these devices. Technical manuals for such computers, a few simple testing devices, and a small parts inventory (consisting mostly of commonly used memory chips, as well as electronic and mechanical parts) were acquired, and the shop started the rather straightforward process of fixing computers.
Within a short period of time word had spread that quick service was available for PC problems, and demand exploded. New, larger quarters were acquired, a counter service was added, the catchy name invented, and serious growth began. Since that time PC Problems plc has become one of the leading service firms in PC repairs, being eclipsed only by the manufacturers and retailers offering warranty servicing.
PC Problems is now faced with a major decision about its line of business. The company has developed a secure reputation for quality, speed and price among individual users of PCs whose machines are out of warranty and who are willing to bring their computers in for repairs. Though this is a good and profitable market, there are others in which PC Problems could probably compete. One such is the on-site repair of PCs in large businesses.
On-site repair of PCs has the same technological knowledge requirements as bring-in repair, but the business itself is substantially different. Among the important new dimensions of the business for PC Problems are the need to set service contract terms for customers, the acquisition of necessary operating assets to make on-site service efficient (equipped service vans, remote communications devices, etc.), and the marketing of such a service to customers familiar with manufacturers' names but not of independent service companies. In addition, to be practical, PC Problems would doubtless be required to offer warranty service to customers who have a mix of old and new machines, which means negotiating terms with manufacturers offering warranties.
PC Problems have put a study team together to evaluate the desirability of going into the on-site repair business, and they have produced the set of information below.
The increase in revenues for PC Problems would begin gradually, with £75000 in the first year, increasing to £150000 in the second, £250000 in the third, and thence 10 per cent per annum thereafter. Because the customers are to be most creditworthy, there is little likelihood of bad debts or eventual non-collection. The company is convinced that projections beyond five years are useless, because of technological change inherent in the industry.
Operations
Because the customer base has changed, PC Problems foresees that accounts receivable (debtors) will increase. The company thinks that approximately 20 per cent of each year's revenues will be paid the following year. The normal increases in other working capital accounts are likely to accompany the expansion implied by the new activity, with cash on hand, and inventories amounting to 10 per cent of revenues each year, and accounts payable (creditors) being itself 10 per cent of revenues. Cash on hand and inventories will necessarily be increased at the beginning of the years in which sales based upon them are expected to occur.
Additional repairmen will cost £20000 in the first year, £40 000 in the second, and will increase at 15 per cent per year each year thereafter. Other direct costs of operating the service (fuel, insurance, training, etc.) are expected to amount to 15 per cent of revenues each year.
PC Problems' accountants have informed the study team that administrative overhead for the project (consisting of management salaries allocated on the basis of revenues) will be 20 per cent of revenues each year. Independent of overhead considerations, it will be necessary to hire a full-time counter-service manager at an annual salary of £10000 to replace the person who will now be devoted full-time to on-site servicing. The latter's remuneration is £15000 per annum. Management remuneration is expected to increase by 10 per cent per annum.
Marketing outlays consist of a £25 000 market survey recently completed by the company, and annual expenses of £15000 in the first year and £10 000 in the second and following years. No increase in marketing outlays is predicted past that point.
Assets
PC Problems must acquire service vans, which will cost a total of £54000. These vans will be depreciated by the straight-line method over a three-year life with a book (accounting) salvage value of £9000. It is expected that the vans could be sold in year five for £15000. The communications equipment of choice appears to be the new portable cellular telephones, which will cost £4000 in total (their operating charges being included in the direct costs described above). The phones will be depreciated by the straight-line method on a four-year life with no book salvage value. They will likely become obsolete by the end of the five-year project life.
It is assumed that any other assets (or liabilities) held by PC Problems as a result of this project can be liquidated at the end of year five for their book values.
Government
PC Problems pays taxes on accounting income at the flat rate of 52 per cent. Interest and depreciation are deductible expenses, as of course are all typically deductible operating costs.
Capital suppliers
The company is planning to borrow enough money to pay for the vans and cellular telephones. The interest and principal payment expectations for these are (£000s):
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|
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t2
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t3
|
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t3
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Interest
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6.96
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5.22
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3.48
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1.74
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0
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Principal
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14.50
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14.50
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14.50
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14.50
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0
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PC Problems generally has a policy of borrowing so as to maintain its capital structure at 25 per cent debt on a market-value basis; that is, the company prefers to have 75 per cent of its total market value in equity and 25 per cent in debt. When it adheres to this policy, its borrowing rate is expected to be 12 per cent per period, and its shareholders require a return of 20 per cent per period. The company is expected to continue with this policy, and its shareholders regard this new line of business as risky, but no more so than the current line.
Topics for review and action
1 In order to undertake an investment analysis, the managers of PC Problems understand that they must estimate the changes that are expected to occur in the cash flows of the company were it to accept the project, but they are not confident of their ability to do that. Suppose you have been hired as a financial consultant to advise the company as to the desirability of the on-site service project. Construct the set of relevant cash flows implied by the above information.
(Note: This is the most difficult part of the case study. You will have most success by attempting to duplicate the process described earlier in the text of the module. Your first step must be to translate the information provided into a format that is useful. We suggest that a set of financial statements (balance sheets and income statements) for each period is the best place to start.)
2 PC Problems also must decide whether the adoption of the cash flows you have estimated above is desirable. Please advise the company about this, using the WACC-NPV criterion.
3 What do you think of the borrowing plans described in the information above? Is this useful information? What relevance does it have for this investment analysis? Is there any particular technique of investment analysis that would utilise that information differently from the way that you have? (Hint: A company's WACC is in part a function of the proportion of debt it uses in financing itself. To test this for PC Problems, recall that the new value increment will be NPV - FCF0" and the borrowing is £58 000.)
4. Upon the presentation of your report, a marketing manager of the company raises the point that the analysis has not considered the possible erosion of carry-in service revenues due to the new service being offered. How should you respond to such a question?